Our Market Perspective and Outlook for 2015

March 13, 2010

The global economy is improving, however, the slow pace of growth and an element of “crisis fatigue” may be casting a shadow over the green lights we see for the economy. There are many reasons to be optimistic for the remainder of 2015.

In the U.S., employment conditions are improving in many sectors. March revisions to the jobs numbers reflected slower jobs growth, with only 126,000 jobs added in March, and downward revisions for January and February. The manufacturing, build- ing and government sectors lost jobs; jobs were added in health care, professional and business services, financial services and retailers.

With the unemployment rate at 5.5%, wage pressures have surfaced. Led by Wal-Mart Stores Inc., several retailers announced plans to raise wages; they include TJX Cos. (T.J. Maxx, Marshalls and HomeGoods), Target, IKEA and Gap. Food services (restaurants and bars) are also feeling wage pressure—McDonald’s announced it is raising wages at company-owned locations. Wage pressures are also being felt in Germany, where wages are expected to increase 3.5% this year, the largest increase since the early 1990s. This could help the companies in France, the Netherlands and Spain who are suppliers to German companies, by making their goods more competitive.

With 68.5% of fourth quarter 2014 GDP driven by consumption, the progress made by U.S. consumers is encouraging going forward. According to J.P. Morgan’s estimates, household net worth during the first quarter of 2015 was $83.9 trillion (based on total assets of $97.1 trillion and total liabilities of $14.2 trillion), up from $67.9 tril- lion during second quarter 2007. The Household Debt Service Ratio has declined to 9.9%, a significant improvement from 13.25% in the fourth quarter of 2007, and better than 10.6% in the first quarter of 1980. Lower oil prices are a windfall for consumers and importing economies who can use the freed-up capital for infrastructure and discretionary spending.

Borrowers with impaired credit in 2007 are becoming eligible for credit and mortgages again, after repairing their credit. Housing sales are expected to be stronger in 2015 due to a rebounding number of new households as the Millennials (born between 1982 and 2000) leave their parents’ homes. According to data tracked by the Bureau of Labor Statistics, 31% of young adults ages 18 to 34 were living with their parents in 2014. A stronger economy and better job prospects can motivate them to leave the nest. In 2015, the Millennials surpass the Baby Boomers as our country’s largest living generation, numbering 75.3 million (versus 74.9 Boomers, ages 51 to 69). The Millennials have delayed marriage, home ownership and children. The clock has been ticking, and the oldest of this population are starting to impact the economy. This is a group with a higher burden of student loans than Gen X before them, which may be a near-term barrier to home ownership; the multifamily rental market stands to benefit from Millennials ready to have their own place
before they commit to a mortgage. For those who can afford a mortgage, it’s a great time to buy.

Entering the Twilight Zone: Paid to Borrow and Paying to Save
In Europe, strange things are happening this year. We have entered the Twilight Zone of negative yields (paying to lend money). The trigger was the January announcement of the European Central Bank’s Quantita- tive Easing (QE) program (which began in March); the ECB plans to buy €60 billion per month through September 2016 and Mario Draghi indicated that he is willing to buy bonds that pay negative interest rates. On January 15th, the Swiss Central Bank started a series of rate and currency gyrations by removing support for the euro relative to the franc, and low- ering its key interest rate from -0.25% to -0.75%. Denmark followed bycutting rates it pays on Certificates of Deposits from -0.05% to -0.20% (charging customers for keeping their money on deposit) and also cut its key interest rate to -0.75% (paying borrowers to borrow). In February, Finland became the first to pay a negative yield on bonds sold at auction, and Sweden declared a negative benchmark interest rate of -0.10%, which it low- ered to -0.25% in March. In early March, a French utility company, GDF Suez, sold $500 million of two-year bonds that pay zero interest. Investors are being forced to longer dated bonds to get any positive nominal yields, and are ac- cepting negative yields. One has to be convinced of serious deflation and/or rates falling even more negative (generating capital gains) or just simply scared to be willing to accept less at maturity than originally invested with yields contributing little, if anything, during the holding period. This is the most bizarre period we have ever witnessed in the fixed income markets. If deflation does not happen, will people feel that they were cheated when they get less back at maturity? Will the banks call the loans made at negative interest rates? We are in uncharted territory.

“’Bonds are like houses,’ said Dave Nadig, chief investment officer of the analytical web- site ETF.com. “Like houses, he said, they are unique, some don’t sell quickly or easily, and reliable price quotes can be hard to come by. By Mr. Nadig’s estimate, there are more than 150,000 individual debt instruments outstanding. Of those, only a few thousand trade as frequently as once a day.” As a result, he said, “establishing perfectly accurate market prices for fixed-income securities with the frequency that many retail investors expect is impossible.”
“Questioning Bond Funds’ Seaworthiness” The New York Times Diana B. Henriques April 12, 2015

It is not just Denmark in which customers are paying to save. Some U.S. customers are having to pay to keep money in the bank because the cost of deposit insurance exceeds what the banks can earn on the deposits. In the U.S., JPMorgan is encouraging institutional customers with large deposits to leave.

Bond Market Liquidity is Shrinking
Inventory continues to shrink as banks move to allocate their holdings to a “Held to Maturity” category to protect their capital when rates rise. According to a March 24, 2015 article in The Wall Street Journal, “Banks Shift Bond Portfolios”, from mid-2013 through year-end 2014, U.S. banks shifted $293 billion of their securi- ties to this category (an 84% increase to $640 billion) which means that one in five in banks’ securities can’t be easily sold; in mid-2013, the ratio was one in nine. Demand by pension funds and insurance companies is competing with the central banks and scared investors, keeping yields suppressed. In March, the Bank for International Settlements cautioned that “market-making is concentrated in the most liquid securities and deteriorating in the less liquid ones”. A shortage of bonds that can be used for repurchase agreements can also disrupt liquidity. For our bond allocations, we want diversification among sectors, high credit quality, and shorter durations to provide liquidity that can weather any disruptions. We think it makes sense to pay for an element of portfolio insurance by taking lower current yields in order to protect principal when interest rates start moving up.

Wescott’s Outlook and Positioning
With the Fed preparing to start raising rates due to a stronger economy and labor market, the U.S. economy seems to be on track for a period of sustained growth, barring any external shocks. The April 2015 World Economic Outlook by the International Monetary Fund provides revised estimated year-over-year growth rates for 2015 and 2016; we summarized the drivers of global growth in the table below. The prospects for global growth in the next two years are encouraging. Most countries are benefiting from lower oil prices; Russia and Brazil are not.

For global equities, we are optimistic that investors will be rewarded in diversified portfolios – the opportunity set goes well beyond U.S. large cap companies that dominated in 2014. Yet we realize that some corners of the market are becoming stretched, and we want to have a balance between the growth opportunities from innovation and the discipline of prudence. In early 2014, we added a long/short equity manager and a stronger tilt toward U.S. Large Cap Value (relative to U.S. Large Growth) in order to protect the portfolio from valuations that can become too euphoric. When the market gets choppy, we expect our value managers to be poised to patiently take advantage of lower prices.

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